Hedging is a commonly used term in the financial markets, especially with futures and commodity traders. Hedging refers to protecting an investment against any possible losses by investing in other products or markets. In simply terms, hedging is similar to ‘insurance’. Just as you would pay a premium when you take out an insurance policy, the method of hedging is also the same. Hedging is therefore designed as an investment that is made for the purpose of protecting the profits made from your previous investments.
In the forex markets, there are many hedging possibilities that can arise although it is often widely misunderstood by many. For most traders, they see hedging as taking a long and a short position in a currency pair simultaneously. The purpose of this kind of trading is to ensure that the trader makes a profit regardless of the market movement. However, there is much more to hedging than merely taking a long and short position.
In this article we outline three common ways of hedging
Correlation based Heging
Correlations are a common phenomenon in the financial markets including the forex markets. Correlations can be either positive or negative. A positive correlation means that two currency pairs or two securities move in the same direction due to common underlying characteristics. A negative correlation is where two securities move in opposite directions. A great example of these correlations is EURUSD and USDCHF which are negatively correlated.
So how can we use hedging based on the currency correlations?
Say for example you were long in the EURUSD and are looking to protect your profits against any adverse price movements. Because EURUSD and USDCHF have a strong negative correlation, we know that any downside moves in the EURUSD could see positive moves in USDCHF. You would therefore place a hedged traded in USDCHF as long positions. The fact that long USDCHF positions also carry positive rollover or swaps ensures you some additional profits as well. The chart below shows the strong negative correlation between the two fx pairs.
Hedging based on corrective moves in the markets
Hedging can also be done within a single currency pair as well. Using this strategy, the profits can be virtually double by trading both the main trend as well as the corrective moves. While this type of forex hedging can be rewarding, it is essential that the trader knows the potential turning points in the markets in order to trade this hedging strategy more effectively.
For example, if you were trading the EURUSD and were long in the market from 1.30, trading in the direction of the main uptrend and the current price is at 1.40. You now see the market consolidating and expect a correction to this uptrend. Therefore, you would now hedge the EURUSD by taking a short position near 1.395 which is basically a counter trend trade. When the correction ends near 1.39, you then close out the short hedged position for a 50pip profit while your main long position is still intact.
Without using hedging, a long position from 1.3 to 1.42 would have made you 120pips in profits, whereas if you add the hedged position’s profits of 50pips, the total return would have been 170pips.
The above type of forex hedging is not allowed by all forex brokers; therefore it is important for traders to check with their forex brokers beforehand if they allow for this type of hedging. The margin requirements for hedging forex currency pairs is also usually much higher, which needs to be kept in mind when following such a hedging strategy.
Hedging with options
Traders can also look for hedging their investments in forex by making use of options derivatives. Because options usually come with a small premium depending on the strike price that you buy the options for, any positions in the forex markets can be hedged or protected by investing in the opposite direction in the markets. So if you were long in EURUSD you would buy CALL options or if you were short in EURUSD, you would be looking to buy PUT options. The amount you pay to buy the options is known as the hedge premium, which is similar to the premium you pay on insurance.
So if the market moves in any direction, your hedged positions in the options markets will ensure that you are well protected. The benefits of using options as a hedge is the low amount that you can pay and with most long term expiring contracts the profit %age return is usually higher than 70%, thus enabling you to maximize the profit potential in case of the market moving in the opposite direction.
This type of hedging strategy is more suited for traders who are invested in the long term and not for intra-day trading positions. Traders also need to have the experience and knowledge of hedging before they can start making use of hedging strategies in their real trading accounts.